Jeff Gundlach who has been spot on with timing his calls for Treasury inflection points, did a quick Q&A with Morningstar summarizing his outlook on the economy. In a nutshell while the DoubleLine manager is still skeptical that inflation may strike, he is convinced deflation is pervasive. To wit: "markets and the economy to date have offered scant evidence to support the inflation case. Stocks are down over the past 10 years. Real estate is down hard over the last five years. Commodities are down sharply over the last two years. Instead of spiking to double digits, bond yields are hugging the ground. M3, which is now calculated only by private economists, is down nicely over the past year. And of course money velocity is moribund: Society has looked into the debt abyss and decided enough is enough with the debt-based consumer economy. So, deflationary forces still prevail. What could shift the balance of forces in favor of inflation? A well-meaning movement to cut the deficit has at long last arrived, maybe. But cutting the deficit that is supporting the consumer economy will directly depress gross domestic product. If that causes not just a look but a step or two into the deflationary abyss, then maybe the inflation case will move to center stage." Sure, let's not forget the collapse in the shadow economy. But let's also not forget that the economy is in a vacuum, and were the Fed not in the picture, we would totally agree. But because the most irrational human being in the world is in charge of said world via his control of the US reserve currency (and irrational because he promotes exclusively policies that benefit the vast minority over the majority), we will have to disagree. And so would the price of gold.
Full interview by Morningstar's Liana Madura
1. You were favorably disposed to municipals at the Morningstar
Investment Conference in June. Is that still the case, particularly amid
mounting concerns about the ability of local governments to meet their
Not much has changed for the muni-bond market since June except that it has performed well. Munis remain in a good place on technical grounds but a bad place on the fundamentals. The technical part is that tax rates are likely to go up. It is difficult for investors to part with their muni bonds because they can't find a generic alternative that will be as attractive on an aftertax basis. As long as we are in a zero-interest-rate environment in the cash market, have 10-year Treasury yields in the mid-2s, and face upward pressure on the marginal tax rates for higher earners, the muni market's technicals will probably keep it firm. The fundamentals, however, are bad and will likely get worse before they get better.
There is a battle brewing between public pensioners and the bondholders who are basically providing the funding for benefits. The scandal in the City of Bell, Calif., is only the opening chapter in what will likely be a long, tragic volume. As it unfolds, the volatility of the muni market should be higher than what we've experienced. Investors who are tempted by the aftertax yield should certainly be buyers on weakness instead of strength. Poster children for the municipal concerns are California general-obligation bonds. At the end of the saga, I deeply believe that California GOs are going to be constitutionally paid, but increased volatility will mean investors can pick their entry spots and buy opportunistically.
2. You were early and correct in signaling the potential for
deflation. However, there are a noticeable number of prominent investors
who still consider inflation a strong possibility. Are there any signs
of inflation as far as you're concerned or do you think the case is
I agree that the inflation case looks compelling on the surface of it. The Fed has run up trillions of dollars in stimulus and guarantees, has printed a trillion-plus dollars via quantitative easing, and seems to be gearing up for QE2. Chairman Ben Bernanke himself vowed in 2002 to drop money from helicopters, should need be, to fight deflation. With a called shot like that, no wonder many investors see inflation as the policy-choice end game. And they may be right.
The problem, though, is that the markets and the economy to date have offered scant evidence to support the inflation case. Stocks are down over the past 10 years. Real estate is down hard over the last five years. Commodities are down sharply over the last two years. Instead of spiking to double digits, bond yields are hugging the ground. M3, which is now calculated only by private economists, is down nicely over the past year. And of course money velocity is moribund: Society has looked into the debt abyss and decided enough is enough with the debt-based consumer economy. So, deflationary forces still prevail. What could shift the balance of forces in favor of inflation? A well-meaning movement to cut the deficit has at long last arrived, maybe. But cutting the deficit that is supporting the consumer economy will directly depress gross domestic product. If that causes not just a look but a step or two into the deflationary abyss, then maybe the inflation case will move to center stage.
3. Given the strong performance of mortgages during the past
year, do you expect more moderate returns from your portfolio going
It certainly seems difficult for much of anything in the fixed-income universe to reprise the strong returns of the past year. Through August, 12-month returns were about 7% for agency mortgage-backed securities, 8% for Treasuries, and in the 20% range for corporate bonds, emerging markets and nonagency MBS. And almost every active manager did even better because tilting portfolios to historically cheap credit was such a common and successful strategy.
Returns in the past six months have been aided by a decline in Treasury interest rates all the way down to just less than 2.5% on a 10-year bond against a backdrop of reasonably good credit-sector performance. This credit improvement came in spite of the apparent weakening in economic growth, an unusual juxtaposition. I should point out that lately agency-guaranteed mortgages (Ginnie Maes, Fannie Maes, and Freddie Macs) have actually underperformed. What was the setup for this underperformance? During the summer, naive market belief held that lower interest rates were unlikely or at least unlikely to trigger any refinancing. That view is now being sorely tested, and refinancing exposure is being repriced with each monthly prepayment report. Some bonds are being hit by refinancings, while others are adjusting to fears of government loan modification and refinance programs. I expect mortgage portfolios will continue to exhibit the wide dispersion of returns exhibited in the past few years since clearly the key variables beneath the MBS markets remain in a very high degree of flux. It seems feasible for a well-positioned mortgage portfolio to achieve high-single-digit returns for a while longer.
4. Given your bearish outlook on the economy, the potential
risk of low inflation or no growth, and the debt/GDP ratio becoming
greater than 90%, what are the chances of the U.S. defaulting similarly
to what happened in Greece? Would you propose any changes to your
Well, Greece hasn't defaulted--not yet anyway. But I see your point, and there is no denying that the market repriced default risk in Greece way, way up. Greece bonds were trading at 5% at year-end. Even in March, when the world's eyes seemed to be opened about the magnitude of the fiscal problem, the yields only moved up to 6%. Then all of a sudden a full-blown crisis was on, and the yields exploded to 20% intraday. Even with the nearly $1 trillion bailout package and the issue supposedly swept under the carpet, you have to notice that Greece bonds are yielding 12% now. The market is certainly hedging its bets on the outcome.
The U.S. government debt/GDP ratio is only at 90% if you look at gross debt, which I think overstates the problem because net debt is what is outstanding if you exclude the government's own holdings. For this calculation I think we should. And there is nothing magical about a 90% level, either, particularly when the nation being considered has many economic advantages, not the least of which is the debt being owed in its own fiat currency. So it is early to be looking for the end game in the U.S. dollar or Treasuries. The market will let us know if this changes. The signal I would look for would be persistent sell-offs in U.S. Treasuries on days accompanied by disappointing economic news. So far that isn't happening. If it does, portfolios will need to be adjusted accordingly.
5. What have been the biggest challenges in setting up your
own management firm, and how do you balance the investment
responsibilities with the administrative ones?
It sure would have been nice not to have been forced to set up DoubleLine without any advance planning or even any know-how about how to proceed at the very first. As it was, I had to go from zero to cruising speed much more quickly than anyone would ever want to go. We had a lot to learn those first couple of months, but now we are probably just that much stronger for the experience. Investors have been so tremendously supportive, and, in particular, the large number of new investors is gratifying. The ability to focus the business rationally has increased so greatly that it far outweighs these challenges.
As for balancing investment duties and administration, I can honestly say that was more of a challenge before than it is now. I have always been pretty good at leading a big investment team, as evidenced by the team's tremendous dedication. Before founding DoubleLine, I ran a department within a division within a subsidiary of a large international bank. All those unproductive layers bring a great deal more administrative responsibility and bureaucratic drag than does running a privately owned, specialized money-management firm. So from that perspective, it's really been a refreshing transformation.